Weighing Down Heinz With Debt

Warren E. Buffett deployed his avuncular charm on Thursday when talking about Berkshire Hathaway’s proposed acquisition of H.J. Heinz. The food company’s chief executive, William R. Johnson, said the deal was a natural next step that wouldn’t lead to big upheavals any time soon.

But for all the reassurances, the deal will turn Heinz into a much riskier company. It will have to operate with a much larger amount of debt on its books, significantly reducing the margin of error for its new owners.

Berkshire will be one of those new owners, taking a 50 percent stake. The other half will belong to 3G Capital Management, a Brazilian-backed investment firm that has stakes in other food and beverage companies including Burger King.

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Berkshire and 3G are taking Heinz private in a $23 billion cash deal, which means its shares will come off the stock market. The deal will mean Heinz will also be liable for the debt used to pay for the deal. After the deal, Heinz could have well over $10 billion of debt, compared with $5 billion now.

One of the effects of the deal is that Heinz’s credit rating will almost certainly be slashed into junk territory. Before the deal was announced, Moody’s Investors Service rated the company two notches above junk.

Defenders of debt-laden deals like this say that they can work with the right owners.

Mr. Buffett said on CNBC on Thursday that 3G would have operational responsibilities. He thinks highly of 3G, whose principal owner is a billionaire named Jorge Paulo Lemann. “I don’t think I’ve ever seen a better developed management group than the one Jorge Paulo Lemann has developed over the years in Brazil,” Mr. Buffett said. “He has been incredible.”

3G has a majority stake in Burger King, which it brought back onto the stock market last year after taking it private in 2010. It appears that 3G and Berkshire may want to use Heinz as a vehicle to make other acquisitions.

But that may turn into an uphill journey. Not only is there all the new debt to pay, Heinz is being bought at a high valuation, roughly 20 times its earnings. When companies are bought at a lofty multiple to earnings, it’s theoretically harder for the acquirers to achieve their investment return targets. To hit those targets, management may decide to cut costs, leading to job losses. Or, conversely, the company may spend a lot of money in new initiatives in an effort to increase revenue.

And there is an element to the deal that shows Mr. Buffett is well aware of its risks.

In addition to common equity, Berkshire is getting $8 billion of preferred shares. These will pay Berkshire a 9 percent return, according to a person familiar with the deal’s terms. That’s a hefty return from a company in a relatively stable industry. Berkshire got only slightly higher — 10 percent – on preferred shares in Goldman Sachs that it purchased at the height of the financial crisis.

More important, the preferred income gives Berkshire significant protection if the value of its common shares falls below expectations. “There aren’t many entities that could do this deal; Berkshire is making sure it’s getting paid for it,” said Meyer Shields, an analyst who covers Berkshire Hathaway for Stifel Nicolaus.

One mystery is why Mr. Buffett didn’t just buy common stock of Heinz on the open market. Berkshire often does that, and currently holds sizable stakes in companies as diverse as I.B.M. and Coca-Cola.

Perhaps he wanted to own more than a small minority stake, but purchasing the whole of Heinz may have been too big a deal, even for Berkshire Hathaway. Indeed, one day, 3G may decide to sell its stake to Berkshire, giving it full ownership. And in the meantime, Berkshire would have earned a solid return on its preferred shares and its common shares.

“‘Buy commodities, sell brands’ has long been a formula for business success,” Mr. Buffett wrote in a recent annual report. Heinz certainly fits that mold today. The big question is whether it still will once its balance sheet has been loaded up with debt.